# The demand for money in Oz (a closed economy) is given by: Md = P (600 – 200r + Y) where P is the aggregate price level,

The demand for money in Oz (a closed economy) is given by: Md = P (600 – 200r + Y) where P is the aggregate price level, r is the (nominal) interest rate in percent and Y is aggregate income. For this exercise treat Y and P as exogenous (given) variables.

a. Graph the money demand equation with M on the horizontal axis, assuming P = 1 and Y = 200. Briefly explain how money demand might vary with changes in P and Y, as suggested by the equation above.

b. Assume that the Central Bank sets the money supply at Ms = 600. Add this to your graph. What is the equilibrium interest rate? And the equilibrium level of money?

c. Suppose that the annual inflation rate is 20% and due to the wise management of fiscal policy by the government, national income, Y, grows 10% during the year. What values of P and Y should you use to estimate the money demand equation next year? Assuming that money supply is constant, calculate the new equilibrium level of interest rates and money and graph the new money demand equation (along with the money supply equation).

d. If the Central Bank wants to restore the interest rate to its original level (that in Part b) what should be the change in money supply? Briefly explain the adjustment process; i.e. why does the change in money supply affect the interest rate?